Techy Thursday Looks at Needs Analysis

Jan 24, 2025

A secure financial future for loved ones begins with a foundation of life insurance. Life insurance can help carry out these hopes and dreams for the future even after one is gone. An important part of a sound financial plan, life insurance provides a death benefit to beneficiaries and can replace some of the income that would have been earned. This can help preserve savings, investments, and other assets for the purposes intended.

Financial Planning Analyzes Need

Life insurance is an essential part of financial planning. One reason most people buy life insurance is to replace income that would be lost with the death of a wage earner. The cash provided by life insurance also can help ensure that your dependents are not burdened with significant debt when you die.

Life insurance proceeds could mean dependents will not have to sell assets to pay outstanding bills or taxes. An important feature of life insurance is that no income tax is payable on proceeds paid to beneficiaries. In order to set future financial goals and to accurately evaluate future needs, an individual must have a good idea of current resources.

This information requires that most people need to derive information from their income tax return, checkbook records, stock and bond records, and other financial statements. For individuals whose asset holdings include close held business interests, real estate, or other assets with mark values or yields that are not easily determined. There are three time periods that an individual needs to evaluate need for.

The early adult years - Premature Death Planning
The middle years - Pre-retirement Planning
The later years - Estate Planning

The primary concerns of life insurance will be to fill three categories of needs: permanent, temporary, and savings. A permanent need for life insurance refers to those needs that continue until death. Temporary needs diminish over time and ultimately disappear. Savings needs include the need to provide for retirement and, in some cases, the need to keep life insurance in force after term insurance premiums would be prohibitively expensive.

The Middle Years would have to focuses on those individuals who find themselves in a stage of life typical of middle-aged Americans. This stage would include legal and financial independence of children; the repayment of all significant debt, including the home mortgage; and almost maximum advancement in a career.

Such a posture might be identified as a pre-retirement planning period. This period generally begins between the ages of 45 and 60 and ends at retirement. The problem of developing financial goals for retirement is more difficult than the problem of developing financial goals during the early adult years.

Estimating the amount needed to fund a retirement is indeed complex because an individual has no idea how long he or she will live. Estimates of retirement needs made by a 50-year-old may involve expenditures planned for 20, 30, or 40 years in the future. Other unknowns are the new forms of retirement living not even on the drawing boards. New opportunities are arising for seniors to continue to work or to participate in educational programs.

The Later Years involve three categories of goals. These goals are:

Living objectives;
Death transfer objectives;
Tax objectives.

Objectives in Need Analysis

Living Objectives involves developing an estate plan to provide for the continual enjoyment of life at a certain level. Such objectives may involve continuing participation in business or farming, moving to an adult community, or participating in an adult educational program

Death Transfer Objectives

The Death Transfer objective involves identifying precisely those people or organizations that an individual wishes to have enjoy his or her property after death. In cases where an individual has had two or more marriages, and children by each marriage, where some children have proved either more worthy or more needy, or where a spouse is wealthy in his or her own right, the development of death transfer objectives may prove difficult.

Clarity and completeness are needed in identifying all assets to be distributed. After the assets have been identified, the next step is the clear designation of the intended recipients of the assets, including the designation of beneficiaries of life insurance policies.

Death transfer objectives are established in a valid will. Life insurance policies can play a key role in achieving death transfer objectives. First, policies can provide a lump sum of cash or a lifetime of income to designated beneficiaries. In the case of spendthrift children, or those inexperienced in money management, the insurance company’s services can prove quite valuable with the insurer guaranteeing to provide a stream of income to such beneficiaries.

Computing Life Insurance Needs

Some experts say one will need 6 to 8 times the annual gross income in life insurance. This is a general rule of thumb, but everyone’s needs differ. One should consider at least how much a family will need for funeral expenses, the mortgage, car loans, credit card debt, education for children, and retirement for a spouse if one should die prematurely. Financial planning professionals apply diversified techniques to determine the life insurance needs of a family. There are essentially three principal areas to calculate need. These areas are:

·Any method of determining a family’s insurance needs will be an estimate since future circumstances will change in unexpected ways and basic assumptions about earnings, interest rates, inflation, and similar factors will vary. Life insurance planning is best conducted with a comprehensive study of the client’s financial needs and concerns.

The process of life insurance planning must begin and end with the objectives and goals of the client being paramount, even if such objectives and goals do not conform with what the advisor considers proper or appropriate values or concerns.

The most important function of life insurance is to replace income lost because of the policy owner’s death. If a father earns $50,000 per year he should have between $300,000 and $400,000 of life insurance under this rule. A similar rule that takes immediate cash needs at death into account is 5 times gross income plus mortgage, debts, final expenses and any other special funding need.

Considering Social Security Benefits

In determining the amount and kind of insurance an individual needs at any point in his or her life, he or she must consider other sources of income or benefits that they have, or for which they may be eligible under other insurance plans, government programs and retirement plans. These other assets will help in determining the amount, and kind, of insurance necessary to meet current and future needs.

An individual can request an estimate from Social Security of the amount expected based on what he or she has paid in. It has been estimated that an individual will need 75% to 80% of his or her current income to maintain a lifestyle after retirement. This means that Social Security benefits will have to be supplemented by income from other sources.

Most workers are covered by Social Security or some other government program that provides survivor benefits to surviving spouses with dependent children and surviving spouses alone after age 60. This is a form of income-replacement insurance and should reduce the present value of the family support obligation accordingly

The amount of Social Security paid to a surviving spouse with one eligible child is 150% of the decreased spouse’s primary insurance amount (PIA) at the date of death. For each additional eligible child, an additional 75% of the PIA is payable. Children are eligible until age 18, or until age 19, if in high school, or as long as they are disabled, if disability occurs before age 22.

A surviving spouse is eligible for benefits if caring for a child under age 16 or disabled before age 22. Otherwise, a surviving spouse is not eligible for benefits until age 60 or age 50-59 if disabled. A spouse alone is eligible for reduced benefits equal to 71.5% of the PIA starting at age 60, or if receipt of benefits is delayed, up to 100 percent of the PIA starting at age 65. A disabled spouse is eligible for 71.5% of the PIA starting at age 50. The total amount payable to the family is subject to a limit, called the maximum family benefit, which is generally about 175% of the PIA.

Some benefits that an individual has now may not be available at retirement time. The Social Security System has been the source of controversy for some time. There is public concern that individuals working today will not be able to count on this system to provide them with retirement income.

When the current generation begins to retire, there may be only two workers paying in for each retired worker needing that income. In order to offset this trend, Social Security tax increases and benefit decreases. Additional changes have been enforced such as increasing the normal retirement age from 65 to 67 or even 70. The idea of “do-it-yourself” financial planning may be sufficient in some circumstances but most will benefit from the advice of a personal financial advisor.

In determining how much life insurance is necessary, agents should ask clients to consider the following questions:

In the even of death, how much money would your family need for living purposes, including paying off the mortgage and other debts?
How long would this amount of income be needed? (It should last at least until the children are out of high school, and preferably until they finish college.
How much Social Security income can be expected until the children are no long are covered?
What are goals for retirement planning?
What funds would be necessary for long-term nursing home care in the future?
How much can be targeted for savings?
What funds would be necessary to provide an income during periods of disability?

Determining Amount of Life Insurance

“Need” is the difference between what the school costs and what it says one can afford to contribute. It is necessary to check that formula when determining eligibility that applies from the school to a child. The federal formula just changed, so even if one thought he or she knew the rules, think again. One may qualify for aid because families turned down in previous years are accepted now.

The federal formula assumes that an individual can afford to contribute up to 47 % of the parents’ annual income after a certain baseline. This baseline is what the federal government has determined one needs to support his or her family after taxes are deducted.

Recent legislative changes mandate an increase in the income threshold for an automatic zero EFC from $30,000 to $31,000 for the 2011-2012 Award Year.

For the 2011-2012 Award Year, a dependent student automatically qualifies for a zero EFC if the 2010 income of the student’s parents is $31,000 or less.

Home equity is not included as an asset meaning that when the school is figuring out how much money one has, it does not count the home. The federal guidelines also no longer look at a farm’s net worth if the person lives and works on a farm.

In some incidents it may be advisable to purchase a term insurance policy that remains in effect at least through the time a son or daughter goes to college. A term policy, which is pure insurance, buys one the greatest death benefit for the premium dollar at age 31. An individual also may consider adding a cash value policy that can be kept once the term policy no longer is in effect. Cash value policies are part-insurance and part-investment. Premiums are higher than with a term policy for the same death benefit. But in return, part of the premium is invested tax-deferred. The money that accumulates in the policy - the cash value - allows future premiums to remain constant.

With a term policy, premiums would go up as one grows older and could become prohibitive as he or she turns 60 and 70. Of course, one must decide whether he or she will want or need to have life insurance at that age. Most people are not so financially sound that they could stop working tomorrow and be able to have enough resources to support their family for a long time into the future. However, this is precisely what happens when the primary bread winner of a family dies or becomes disabled. For this reason, life and disability insurance are a critical piece of a family’s financial profile. But how does a family determine the proper amount of insurance?

Although there are certain “rules of thumb” that may be used in order to estimate the insurance need, they are very simplistic and often do not consider such important factors as the family’s current net worth or the ages of the family members. Such rules of thumb normally utilize a multiple of earnings approach.

One such rule is to estimate the amount of life insurance by multiplying the wage earner’s income by a factor of 6 to 8. Thereby, a physician earning $100,000 annually should have $600,000 to $800,000 of life insurance. A similar rule takes immediate cash needs into account. The rule is 5 times gross income plus mortgage, debts, final expenses and other special funding needs. Assume the same physician has a mortgage of $300,000, medical school debts of $100,000 and desires college funding requirements for his or her children totaling $200,000. The insurance need in this case would be $1,100,000.

The “rules of thumb” can provide a wide disparity of solutions. Without looking at a family’s entire financial profile, it is difficult, if not impossible, to accurately determine the proper amount of life or disability insurance. The most reliable approach to determining the proper level of insurance is by way of a needs analysis. This type of analysis determines the amount of money needed to support the family and pay down outstanding liabilities, reduced by current asset holdings and future receipts of income.

The first category of need is often the most underestimated or neglected—the current cash need upon death. This category of need only exists when determining the life insurance need since disability insurance is focused on income replacement. By including debt liquidation and education funding in this category, the insured will be sure to leave the family with a roof over their heads and assures that the children will be able to attend college.

The second category is the estimated income need for the family. This amount will be different depending upon whether the needs analysis is being performed for life or disability insurance. For life insurance, the income need is determined by estimating the surviving spouse’s annual income requirements over his or her remaining life expectancy This amount will typically range from two-thirds to three-quarters of the family’s current income.

Once this amount is estimated, an assumption must be made regarding an inflation percentage. This is the amount by which the income requirement must grow each year. A second assumption must be made regarding after-tax earnings. The difference between the after-tax earnings rate and the inflation factor is the percentage which is applied to the income need in order to determine the present value of the income need. This amount represents the capital which must be set aside currently in order to ensure the surviving spouse receives the annual income each year for his or her life.

When calculating the income need it is important to factor into the equation the income needs for children. Often, the need will be determined through a particular age, usually 18 or 21. This calculation must be performed for both life and disability insurance needs analyses. The income need may be reduced by an assumed amount of earnings by the spouse. However, it is common for people to disregard this amount in order to prepare for a worst-case scenario when one spouse dies or becomes disabled and the other is unable to work.

The total current cash need and income needs are satisfied by the capital assets available to the family. This will typically include cash, savings and other liquid investment assets. Do not include the value of assets which will not be sold in order to generate cash, such as the family home. The capital assets will also include the present value of any pension or other retirement benefits which will become available at some point in the future.

It is also important to factor in the present value of benefits which will be received from the Social Security Administration. Upon death, the children of the decedent may be entitled to a monthly check until they reach age 18. The surviving spouse will typically begin to receive benefits at normal retirement. A disabled worker will begin to receive Social Security benefits upon meeting the Administration’s definition of total disability.

The difference between the family’s total current cash and income need, less the capital assets, is the insurance need. From this point, the family must make a personal determination whether or not to purchase insurance equal to the amount of the calculated need. Many times the calculated need will be very expensive. The calculated insurance need, if fully funded, may make a dent in the family’s lifestyle due to the high premium requirements for a large policy.

Human Life Value Concept

A second approach used to estimate life insurance needs is based on the human life value concept. The human life value concept has often been applied in wrongful death litigation and basically holds that the measure of the economic value of a life to those who depend on that person is the present value of the future earnings potential of that person.

A person’s human life value depends on numerous factors including future income levels, taxes, education, training, promotions, and various normal decremental factors such as the possibility of illness, disability, periods of unemployment, and the like.

This approach takes into account the factors of estate clearance costs, the income the family needs to readjust to a new lifestyle after the death of the breadwinner, income for the family until the children leave the home, life income for the surviving spouse, special needs of the family such as college education for the children, and other needs. Reasonable estimates of the present value of future earnings can usually be determined using basically four inputs or assumptions. These are:

current annual after-tax earnings;
the projected rate of growth of earnings;
the future working lifetime;
an after-tax discount rate.

Given these four factors, the present value of future earnings may be computed using the present value of an annuity formula. The formula assumes earnings are paid annually in the middle of the year, which is a reasonable approximation to monthly or other periodic payments throughout the year.

Assuming that an individual’s after-tax income is $50,000 per year the agent should estimate that it will grow at an average annual rate of 5% and he is approximately age 35, expecting to work for 30 more years. In this incident an appropriate after-tax discount rate is 6 percent.

So the present value of his future earnings is about $1,275,000. This figure is the amount that, if invested today at a 6% after-tax rate of return, could provide an after-tax income stream payable in the middle of a each year for the next 30 years, with the initial after-tax amount starting at $50,000 and then each subsequent payment will grow by 5%. After 30 years, the entire $1,275,000 would be used.

Income Replacement Approach

The income replacement approach to life insurance needs analysis is based on the premise that the basic objective of life insurance is to replace some or all of the earnings lost if an income-producing family member should die.

In other words, the insurance should be equal to the value of that person’s future earnings potential to the surviving family members. Although the basic premise may be questionable because it ignores other equally valid reasons why life insurance may be purchased, the method does allow one to estimate a theoretical maximum based on the idea that a person should never be worth more economically to beneficiaries dead than alive. This method may provide a more accurate starting point than simple rules of thumb while still being relatively easy conceptually – if not computationally – to understand.

Retirement Needs Approach

The third approach is the retirement needs approach. This approach calls for coordinating life insurance or annuity purchases with other sources of revenue such as Social Security, pensions, and investments in order to achieve a predetermined retirement income.

Most families purchase life insurance, at least initially, to protect their young, growing families. As their children grow up, they may feel that their need for insurance diminishes. The fact is, for many reasons, this need does not go away.

Family Support Ratio

Under the income replacement approach, insurance value is always less than human life value. The portion of after-tax income spent by the insured for self-maintenance is not available for support of the family so only the remaining portion is devoted to or spent in support of the family. It is often assumed that about 25% of after-tax income is spent for self-maintenance and the remaining 75% for family support.

However, this ratio may vary widely from family to family. Under the basic premise of the income replacement method, one of the important elements of family support is the cost of the insurance itself. Since the amount spent for insurance is not otherwise available to support the family’s standard of living, this cost should further reduce the proportion of income that is insured to support the surviving family members’ standard of living. Once an estimate of the breadwinner’s human life value is determined, that amount should be multiplied by the family support ratio.

Now the amount figured for the Family Support Ratio is not necessarily the amount of additional insurance required. This amount should be further reduced by the amount of any assets that are currently available to fund the survivor’s income needs and by an life insurance currently in force. Among the assets that should be counted are marketable securities, savings account balances, and the like, as well as current vested account or benefit balances in employer-sponsored pension and profit-sharing plan, 403(b) tax-deferred annuities, IRAs, SEPs, and Keogh plans.

Some financial advisors feel that the family support ratio should also be increased to account for contributions or credits that would be made to employer-sponsored retirement plans whether they are qualified or not qualified, that is while the breadwinner is living.

The family support ratio should be computed based on the reported after-tax income increased by the effective after-tax value of the 401(k) contributions. If the family support ratio is otherwise assumed to be 70%, it should be increased to 74.2% to account for the equivalent after-tax value of the employer-sponsored plan (70% x 6% = 4.2%)

Capital Needs Analysis

The amount of insurance should be sufficient to cover a family’s economic needs, if the breadwinner were to die tomorrow. Therefore, the starting point in capital needs analysis is an evaluation of income needs against the estimated income to be received upon the death of the bread winner.

Capital needs analysis has, as its purpose, analyzing a client’s needs and determining how life insurance can best meet those needs and how much life insurance to purchase. Capital needs analysis uncovers a client’s general financial problems or deficiencies so that he begins to recognize his needs.

Capital needs analysis helps the agent to sell the right amount of life insurance to his client for the right reasons. In today’s competitive market, agents must provide a needs’-based analysis for their clients, and they must generate reliable recommendations based upon this investigation. Learning how to effectively determine needs permits the agent to offer a complete selection of financial products and services.

The average American family may find it extremely difficult, if not impossible, to accumulate a meaningful amount of assets. For many Americans, life insurance makes up at least 75% of the estates left behind.

Many proponents of term insurance believe no one will need protection after age 55 or 65 because the cost of such coverage is prohibitive at these ages. Since most people die after that age, and additional capital is frequently needed by the survivors, the cost of ongoing term insurance would put a significant drain on the family cash flow.

Business Overhead Expense

A business overhead expense plan helps protect a company or owner-operator from the financial difficulties associated with a disability. Fixed overhead expenses can constitute a major portion of a company's operating budget. If a certain individual's on-the-job performance is critical to the operation of a business, their disability can be devastating.

Fortunately, the IRS recognizes the significant difficulties a disability can impose on a company and provides for a tax-advantaged plan to minimize the financial repercussions. A specific type of contract known as an “Overhead Expense Disability Policy” reimburses the company or individual for the overhead expenses actually incurred with a set maximum during a covered disability. If this type of contract is used, the premiums paid are deductible as a business expense. When proceeds are paid out during a disability, they are taxable as income. Then, when the business overhead expenses are paid, they are typically tax deductible.

If a standard disability contract is used instead of an Overhead Expense Disability Policy, the premiums are not tax deductible. However, during a period of disability the proceeds that are received are not taxed as income. Even if the proceeds are used to pay the business overhead expenses, the premiums are not tax deductible and the proceeds are tax-exempt if a standard disability contract is used. The set amount of the benefits are not dependent on the amount of business overhead expenses.

When developing a business overhead expense plan, a company or owner-operator should carefully consider the tax ramifications of the different types of insurance policies. They must decide whether current tax deductions for premiums paid or tax-exempt proceeds are most important.

Business Life Insurance Needs Analysis

A study conducted by Dun & Bradstreet indicated 47% of all business failures are attributable to a lack of management and finances. The death of a key employee can cause serious problems for the business. Life insurance is used in business applications to insure key employees, fund buy/sell agreements, and in various compensation arrangements, such as in death-benefit only plans, section 162 plans, split-dollar arrangements, and in qualified pension and non-qualified deferred compensation plans.

The primary function of life insurance is to offset the economic loss that comes with the death of an individual – to compensate for the human value that disappears with death. They take care to insure the physical assets against loss from fire, tornadoes and other hazards. Yet, protection against the loss of human life values, which is provided by life insurance on the key people, may be a far more vital need. The probability of loss is considerably greater because it has been estimated that the chance of death of a key executive at age 45 is 14 times greater than the chance of a fire loss. It increases to 17 times at age 50, and to 23 times at age 55.

Evaluating Business Insurance Needs from Financial Statements

The financial statements might possibly disclose the presence or the absence of various business life insurance needs. Let’s look at some of the indicators from the financial statements, of insurance needs.

Ø Funding Buy-Sell Agreements - A balance sheet often will disclose how a company’s present buy-sell agreement is funded, or how a proposed insurance plan could be funded. At any rate, the presence or absence of insurance cash values on a balance sheet calls for further investigation into the prospect’s business continuation plans.

Ø Absence of Cash Values - The absence of cash values on the balance sheet might indicate that the company has a business continuation plan that is either not funded by life insurance, or it is funded by term insurance or funded by a permanent policy that has yet to show cash values. Or the company has neither a business continuation plan nor enough present insurance in order to fund one.

Ø Presence of Cash Value - The presence of a life insurance cash value indicates one of three things. Either the company has an entity-purchase business continuation plan, but more insurance is needed to fund the plan sufficiently or the company has purchased insurance for some purpose other than business insurance. Then the company might have some type of entity-purchase business continuation plan funded adequately by insurance.

Whether a balance sheet contains insurance cash values or not, in order to determine the correct need with the company, an agent should investigate the prospect’s business continuation plans.

Even the presence of a buy-sell agreement should not discourage an insurance agent from investigating to determine if the needs are completely covered. An insurance agent can take the most current balance sheet and compare it to the balance sheet for the year in which the agreement was last considered.

Amount Of Key Employee Insurance

The key executive’s employer often has a difficult time arriving at the amount of insurance it should purchase on the employee’s life. The employer is dealing with human life values, not property values, so no set formula or rule can be used. The determination of insurance amounts in a buy-sell insurance case, for instance, is much more precise because the assessment of the insurance amounts is determined largely, again, by the property values. In many key-executive insurance cases, however, the amount of insurance will be established in more or less arbitrary fashion.

Nevertheless, there are a few points that might be considered in reaching a reasonable figure. Let’s look at these questions and what the answer may be to them.

· How much would it cost to replace the person in question? A new person will have to be hired to take his or her place at death. Will the new individual demand more salary? Would the new individual likely do the job as well? How long would it probably take to train the new person to reach the proficiency level of this key employee? How much, then, could the company be expected to spend in finding and training a capable successor?

· What proportion of the company’s actual loss is it willing to insure? What proportion of the company’s desire to insure completely against the loss of the key individual may be limited by working-capital considerations. · How much is this person worth to the firm in net profits? The executive is making a definite contribution to the firm’s success and is accountable for some proportion of its profits.

·How much would it cost the business if this executive died today? This depends on how difficult it would be to replace the talents and skills of the key person. Would the company itself collapse without this person?

What Life Insurance Provides for a Business

Life insurance cannot replace the mind that has been lost to the business when death strikes. But life insurance indemnifies the business for the cash value of the services that will be lost, so far as those human life values can be measured. Life insurance can provide the business with cash

to cover the special expenses of finding, securing and training a new person to take the deceased’s place;
to assure creditors that their loans are safe
to cover the mistakes that the business will continue operations
to assure customers that the business will continue operations
to keep the business running
to cover the mistakes that the deceased’s successor will make until he or she learns the things the deceased knew from experience
to be made available for many uses that cannot be determined in advance because they depend upon the particular circumstances of that particular business at that particular time.
to cover the losses involved in a less capable successor’s mistaken decision.

The key executive is a valuable business asset, vitally important to the continued welfare of the firm. Without insurance to offset the loss of a key person’s death, there may be a very serious interruption of the flow of business profits.

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